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Compounding and Discounting

1. The document discusses the time value of money and how compounding and discounting allow the calculation of future and present values of cash flows. 2. Key concepts include effective interest rates, annuities, perpetuities, and amortization of loans. 3. Formulas are provided for compounding, discounting, and calculating payment schedules for loans.

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Shivansh Dwivedi
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1K views20 pages

Compounding and Discounting

1. The document discusses the time value of money and how compounding and discounting allow the calculation of future and present values of cash flows. 2. Key concepts include effective interest rates, annuities, perpetuities, and amortization of loans. 3. Formulas are provided for compounding, discounting, and calculating payment schedules for loans.

Uploaded by

Shivansh Dwivedi
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPT, PDF, TXT or read online on Scribd
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CHAPTER FIVE

Time Value of Money


Learning Objectives

1. Describe how compound interest works.


2. Explain what is meant by the time value of
money.
3. Define discounting and compare it to
compounding.
4. Explain the difference between the nominal
and the effective rate of interest.
5. Discuss how discounting and compounding
affect effective yields and payment levels of
term loans.
Introduction

 Time value of money – refers to the


fact that $1 received today is worth
more than $1 received tomorrow

 Compounding and discounting form the


basis for the valuation process used in
finance.
Basic Compounding
 The table shows the ending wealth that an investor could
have accumulated by the end of 1998 had he invested
$1000 in 1938
 Cumulative Wealth ($000s)
1938 1948 1958 1968 1978 1988 1998

Stocks 1,091 2,103 10,128 27,639 51,038 193,038 485,068

Bonds 1,056 1,434 1,623 2,084 3,691 10,480 37,720

T-Bills 1,006 1,058 1,244 1,893 3,678 11,489 23,253

U.S. 1,344 2,651 15,602 44,804 66,815 303,322 2,260,431


stocks
Compound and Discounting
Variables
P = current cash flow
F = future cash flow
A = the amount of annuity
i = the stated (or nominal) interest rate
I = dollar amount of interest
r = the effective period rate of return
n = # of periods under consideration
m = # of compounding periods per year
PV = present value of a future cash flow(s)
FV = future value of a cash flow(s)
Compounding and
Discounting

Fn = P(1 + r)n
OR

FV = PV(1 + r)n
 The equations represent the
compounding relationship that is the
basis for determining equivalent future
and present values of cash flows
Compounding and
Discounting

PV = FV x 1
(1 + r)n

 Discounting – the process of converting


future values of cash flows into their
present value equivalents
Cash Flows Across Time
Periods
 To determine the present and future values
associated with multiple cash flows that are
paid through time, the following process is
used:
1. Choose a point in time as the basis for
economic comparison
2. Shift cash flows that occur at different times
into equivalent amounts at the chosen point
in time through compounding or discounting
3. Add or subtract all of these equivalent cash
flows to obtain a net total
Annuities

 Annuity – series of payments over a specific


period that are for the same amount and are
paid at the same interval where the discount
rate is applied to all cash flows
 Ordinary Annuity – payments that take place
at the end of each period
 Examples of annuities include interest
payments on debt and mortgages
Annuity Formulas

 Future Value of an annuity


 (1  r ) n  1 
 

FV  A  
 r 
 
 Present Value of annuity
 1 
1  1 (1  r ) n 
PV  A  
 r 

 

Annuity Due

 Annuity due - payments are made at the


beginning of each period
Example: leasing arrangements

 To compensate for the payment made at the


beginning of the time period, multiply the
future or present value annuities factors by
(1 +r) to shift them by one period
Perpetuities

 Exist when an annuity is to be paid in


perpetuity
 Present value of Perpetuity

A
PV 
r
Varying Compound Periods

 Any time period can be chosen for


compounding

 Effective interest rate – actual interest


rate earned after adjusting the nominal
interest rate for the number of
compounding periods
Varying Compound Periods

 Effective annual rate formula


m
 i 
r annual   1  1
 m

 Effective period rate formula


m
 i  f
reffective  
 1  1
 m
Amortization of Term Loans

 Compounding and discounting are


found in debt financing
 Under term loans or mortgages,
borrower repays original debt in equal
instalments
 Instalments consist of two portions:
1. Interest
2. Principle
Amortization of Term Loans

 Common computational problems with term


loans or mortgages include:
1. What effective interest rate is being charged?
2. Given the effective interest rate, what amount of
regular payments have to be made over a given
time period, or what is the duration over which
payments have to take place given the amount?
3. Given a set of repayments over time, what portion
• represents interest on principle?
• represents repayment of principle?
Repayment Schedules for
Term Loan and Mortgages
 Most loans are not repaid on an annual
basis
 Loans can have monthly, bi-monthly or
weekly repayment schedules
 In Canada, interest on mortgages is
compounded semi-annually posing a
problem in calculating the effective
period interest rate
Summary

1. Compounding specifies how a given amount


of money grows over time at a particular
rate of interest. By compounding at a rate
that represents the time value of money,
we can calculate future values of current
cash flows.
2. Discounting is the inverse of compounding;
it allows us to calculate present values of
future cash flows
Summary

3. Because of time value of money, cash flows


that occur at different points in time can be
compared only by transforming them
through compounding or discounting into
equivalent flows with reference to a
particular point in time.
4. The basic formulas for compounding and
discounting are independent of the choice of
the base period. (cont’d)
Summary

(cont’d)
However, because of institutional
conventions, one must adjust the formulas
to distinguish between the nominal or
quoted rate of interest and the effective
rate of interest.
5. Loans with level repayments can be split
into interest and principle.

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